It goes without saying that Microsoft (NASDAQ:MSFT) earnings on Wednesday are important for the market. Microsoft stock, of course, now has the highest market capitalization in the world, narrowly ahead of Amazon.com (NASDAQ:AMZN) amid the retreat by Apple (NASDAQ:AAPL).
And so any earnings-related moves in MSFT on Thursday will impact broad market indices like the Dow Jones Industrial Average and the S&P 500. But even those one-day effects aside, Microsoft earnings look like a potential bellwether for the market as a whole.
After all, the Microsoft story at this point is well-known. It’s even converted a long-running skeptic like myself. The shift to cloud-based offerings has helped margins and revenue growth.
The Azure platform is growing like gangbusters, undercutting the first mover advantage of Amazon Web Services and, to a lesser extent, Alphabet (NASDAQ:GOOGL,GOOG). Efforts to expand elsewhere – for instance with Surface devices, or in trying to take on Salesforce.com (NYSE:CRM) with Microsoft Dynamics – are having some, if mixed success.
With the story known, the argument over Microsoft stock, however, now largely comes down to valuation. With Microsoft showing some volatility of late, the reaction to Thursday’s earnings report could highlight what investors are willing to pay for quality – when it comes both to MSFT and the market as a whole.
Will MSFT Stock Gain Again After Earnings?
Microsoft has a strong track record of beating expectations. Going back over four years since the Q4 FY14 report, Microsoft has missed just once each on the top and bottom lines.
That includes a blowout fiscal Q1 report in late October. Revenue rose 19% and net income some 34%. In that context, even though the year-prior comparison is tougher, as management pointed out on the Q1 conference call, Q2 expectations seem modest. The Street on average is looking for a 12.4% increase in revenue and a 13.5% rise in adjusted earnings per share.
Indeed, it’s worth pointing out that revenue consensus of $32.5 billion is only modestly above guidance. The midpoint of guided segment ranges on the Q1 call totals $32.3 billion. Given that Microsoft seems to guide conservatively (as do many companies), revenue consensus in particular looks potentially light.
Between history and guidance, investors should expect an earnings beat on Wednesday afternoon. But that alone doesn’t guarantee an upward move in Microsoft stock.
How Will Microsoft Stock React?
MSFT stock did gain after the big Q1. But, really, even that blowout report did little for the stock. MSFT had dropped 5%+ the day of earnings amid an ugly day in the broad markets. Gains after earnings simply recovered those losses. In barely two weeks, Microsoft stock again was down from pre-earnings levels. By December, the stock was at a seven-month low.
And so it’s not clear how investors will react to MSFT next week. The stock has moved back toward the middle of its range. At these levels, Microsoft stock isn’t particularly cheap: even backing out net cash, the stock trades at 22x FY19 EPS estimates.
Any move here post-earnings, then, gives a signal as to what investors are willing to pay for Microsoft stock. I personally thought the sub-$100 levels in November were too cheap but also called a top when Microsoft traded at $115 after raising its dividend two months earlier.
For a number of investors, though the range might be different, the thought process likely is similar. MSFT at this point is largely a valuation play. Few expect Azure growth to suddenly decelerate to zero and/or for Microsoft to fall 40%. Even fewer expect PC unit sales to suddenly accelerate, or for MSFT to gain 60% over the next twelve months.
This is an argument about valuation. From here, 18-19x earnings looks attractive. 22-23x earnings – not so much. The reaction to earnings might give a handle on how the market as a whole sees that range.
And that in turn is valuable information for investors across the market looking out to 2019. If Microsoft posts a strong quarter, and investors sell the stock anyway, that’s an issue for the market.
If investors aren’t willing to pay more than 20x-21x earnings for this business, what does that mean for the stocks in the rest of the market whose stories aren’t as good, whose moats aren’t as strong, and whose growth isn’t as steady?
Conversely, a strong reaction to a beat-and-raise quarter further suggests that the ugly Q4 in the markets might be a thing of the past.
Again, Microsoft’s Q1 report in October was one of its best ever in terms of beating expectations. The stock wound up plunging just weeks later as investors sold everything in sight. If the reaction is different this time around, investors are back to focusing on quality and corporate earnings, which should inspire some confidence as the rest of earnings season rolls on.
From a long-term standpoint, Microsoft earnings actually don’t seem that important to MSFT stock. But from a near-term trading standpoint, the reaction could give quite a bit of information as to how 2019 might play out. That’s true not just for Microsoft, but potentially for the market as a whole.
As of this writing, Vince Martin has no positions in any securities mentioned.